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passive investing

Also called: passive fund

Holding a whole market through an index fund instead of trying to beat it.

Passive investing means holding a whole market through an index fund instead of trying to pick the winners inside it. The fund simply owns what the index owns, in the same weights, and trades only when the index changes. People search for it as "passive vs active investing", and the core of the answer is arithmetic, not opinion.

Before costs, all investors together earn the market's return, because together they are the market. Passive investors earn that return minus a small fee. Active investors as a group also earn the market's return before costs, but pay more for research and trading, so after costs the average active dollar must trail the average passive dollar. Some active managers beat the market in a given period; picking them in advance is the hard part.

Passive does not mean doing nothing or taking no risk. A passive world stock fund falls when the market falls. The choices that remain are real: which market, how broad, the stock and bond mix, and keeping all-in costs low.

Example

Grace shows Ethan a toy market worth $100,000 that returns 6% in a year. Half of it, $50,000, sits in a passive fund costing 0.1%; two active funds hold $25,000 each and cost 1.5%. One active fund earns 10% before costs, the other 2%, so together they earn the market's 6%.

After costs, the passive half earns 5.9%. The active funds earn 8.5% and 0.5%, an average of 4.5%. The 1.4-point gap is simply the cost difference: of the market's {D}6,000 gain, {D}800 goes on costs and investors keep {D}5,200.

Common mistakes

  • Assuming passive means safe; an index fund carries the full fall of its market.
  • Calling a narrow theme or single-country index fund "passive" as if it were the whole market; it is still a concentrated bet.
  • Comparing funds by headline fee only, while FX, platform and spread costs decide the all-in price.
  • Holding a passive fund but trading it actively, which brings back the costs and the timing mistakes.